Currently, the Internal Revenue Service (“IRS”) has the discretion to assess hundreds of thousands of dollars in penalties under §6707A of the Internal Revenue Code (“Code”) in an attempt to curb tax avoidance shelters. This discretion can be applied regardless of the innocence of the taxpayer and was granted by Congress. It works so that if the IRS determines you have engaged in a listed transaction and failed to properly disclose it, you will be subject to a potentially draconian penalty regardless of any other facts and circumstances concerning the transaction. For some, this penalty has been assessed at almost a million dollars and for many it is the beginning of a long nightmare.
However, there is some relief in sight. If legislation currently pending in Congress is passed, relief could be granted and this nightmare could end for many taxpayers. Further, on July 6, 2009, Commissioner Shulman of the IRS sent a letter to Honorable John Lewis that he is “concerned that because the current statute applies uniformly without exceptions and without regard to the amount of tax in question, some taxpayers are caught in a penalty regime that the legislation did not intend.” Commissioner Shulman has agreed that in light of the current legislation, the IRS “will not undertake any collection enforcement action through September 30, 2009, on cases where the annual tax benefit from the transaction is less than $100,000 for individuals or $200,000 for other taxpayers per year.”
Let us provide an example of the impact of this penalty. One of our clients requested our assistance in connection with the IRS audit of their 412(i) plan. Pursuant to a settlement with the IRS, the 412(i) plan was converted into a traditional defined benefit plan. All of the contributions to the 412(i) plan would have been allowable if they had initially adopted a traditional defined benefit plan. Based on our negotiations with the IRS agent, the audit of the plan resulted in no income and minimal excise taxes due. This is because as a traditional defined benefit plan, the taxpayers could have contributed and deducted the same amount as a 412(i) plan.
When our client thought it was close to concluding the audit, they received a notice from the IRS. The IRS assessed our client penalties under §6707A of the Code in the amount of $900,000.00. This penalty was assessed because our client allegedly participated in a listed transaction and allegedly failed to file the Form 8886 in a timely manner. Essentially, once the assessment is made, in most cases it is non-negotiable with the IRS agent who has imposed it and the only recourse is to appeal the assessment with IRS Appeals Office. Upon exhaustion of all administrative remedies with the IRS Appeals Office, the IRS has taken the position that there is no Tax Court jurisdiction. Thus, the only recourse is to pay the penalty and apply for a refund with the District Court.
Another client of ours never received the letter assessing the §6707A penalty and was still in the midst of the 412(i) audit when he heard a knock at his office door. An IRS collections officer showed up at his office to make “payment arrangements” on a $200,000 §6707A penalty. We successfully worked to have all collections activities rescinded and provide us with more time to appeal the assessment of the §6707A penalty with IRS Appeals.
Another client of ours had entered into the Global Settlement Initiative under IRS Announcement 2005-80 per the advice of previous counsel. Under that settlement, he unwound his plan, paid all the income taxes and penalties. After signing the Closing Agreement, he was sent a letter that assessed the §6707A penalty in the amount of $600,000. He was over 65 years old and after being denied his appeal with the IRS Appeals Office, he was forced to use all of his savings and retirement funds to pay the penalty. Is this truly what Congress imagined in 2004 when it gave the IRS the tools to assess this penalty?
The issue of the harsh impact this penalty is having on taxpayers was addressed by the National Taxpayer Advocate’s General Report to Congress. In the 2008 National Taxpayer Advocate Annual Report to Congress, the National Taxpayer Advocate recommended to Congress to “[m]odify Internal Revenue Code §6707A to Ameliorate [its] Unconscionable Impact.” The National Taxpayer Advocated acknowledged the “penalty is having unconscionable and possibly unconstitutional impact on taxpayers who have done nothing wrong.” This is because of the disproportionate penalties to the “abuse” and the fact that upon assessment the penalty cannot be appeal with the Tax Court.
The National Taxpayer Advocate further stated that “this penalty be imposed without regard to culpability may have the effect of bankrupting middle class families who had no intention of entering into a tax shelter.” Further, the US Chamber of Commerce in their statement to The Committee On Small Business Of The United States House Of Representatives called for a moratorium on §6707A penalties. The US Chamber of Commerce recommended an “immediate moratorium on the assessment and collection of the IRC Section 6707A penalty until the statute can be thoroughly reviewed and recommendations can be made to carry out the intention of Congress without the disproportionate and probable unconstitutional impact of current law on small businesses and their owners.”
It appears that Congress is now becoming concerned about the application and severity of the §6707A penalty, as evidenced by the most recent bill introduced by Senator Nelson. On April 1, 2009, Senator Nelson of Nebraska introduced Senate Bill 765, which would amend the Code to provide for: (i) a reasonable cause exception to §6707A of the Code; (ii) a proportionality requirement between the amount assessed under §§6707A and 6662A of the Code; and (iii) a retroactive effective date for any assessment on or after January 1, 2008. The bill was read and now resides with the Committee on Finance. On April 28, 2009, Representative Donnelly of Indiana introduced H.R. 2143, which mirrored Senate Bill 765 and which has since been referred to the Committee on Ways and Means. We hope that the pending legislation will prove successful and provide some much needed relief to those taxpayers who are faced with this penalty.
If you are subject to the §6707A penalty or are currently engaged in an audit with the IRS that involves a listed transaction, we strongly recommend that you seek advice from a tax professional. From the assessment of the penalty through the appeals process, there are many traps that only a tax professional with experience in these matters can assist you competently.
Disclaimer Required by IRS Rules of Practice:
Any discussion of tax matters contained herein is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed under Federal tax laws.